What should government do in responding to a recession? It is generally easy to provide a quick answer for a government intervention in form of counter-cyclical monetary and/or fiscal policy. Although the Real Business Cycle (RBC) school of thought asserts that recession is a natural way for the economy to “heal itself” thus there is nothing government can do, the contemporary recession that seems to be longer in duration forces practically any government to intervene to push back the economy into its long run growth. Furthermore, recent global economic crisis re-establish the role of fiscal policy to stabilize the economy since the widely accepted tools to counter recession, monetary policy, hits the Zero Lower Bound (ZLB) and drastically lose its effectiveness.

A natural question that follows is what the optimum policy is. Conventional wisdom says that both monetary and fiscal policy should be used together to fight any recession. However, from what I read on the literatures on stabilization policy, the answer is not that simple. The main cause of the recession seems to be important determinant of an optimum policy. Is the recession caused by monetary policy? Is it a result of a crisis in the financial sector? Or is it a result of an external shock in commodity price? The availability and flexibility of the stabilization tools are also important. Is monetary policy constrained? How deep is the political factors influence the conduct of fiscal policy? What is the state of fiscal and monetary coordination? Thus, which tool to be used to counter which type of recession in what circumstances seems to be important question to answer.

Economic literatures generally agree that monetary policy should be used first. Mankiw and Weinzierl (2011)[2] argue that there should be a hierarchy in using stabilization policy. Using simple two-period model where price is sticky in the short-term but flexible in the long term, households welfare can be raised when stabilization policy obey certain level of hierarchy. The first level of the hierarchy applies in a recession where Zero Lower Bound (ZLB) is not binding, that is when nominal interest rate is far from zero. Here, conventional monetary policy is sufficient. All that is needed is for monetary authority to cut the short-term interest rate to revert the economy back toward full employment. Fiscal policy should be used for medium and long term consideration. Indeed, using game theoretic approach, Franta, et. al. (2011)[3] shows that in the medium term an explicit monetary commitment ahead of fiscal policy lead to a better outcome for both monetary and fiscal policy.

The second level of the hierarchy applies when the ZLB is binding, when the short-term nominal interest rate is zero or very close to zero. Here, monetary authority should use its ability to influence long-term interest rate. By buying long term assets, unconventional monetary policy aims to commit for a higher inflation target in the future to restore the economy back into its long run growth. Again, fiscal policy should be used for medium term consideration. The third level applies when ZLB is binding and the monetary authority unable to commit for future monetary policy, say because of regulatory constraint. Then fiscal policy can be used to do what monetary policy would do. Here, an example would be a targeted tax cut policy to incentivize component of spending that is sensitive to interest rate, for example investment. Indeed, stylized fact of business cycle shows that in recession investment is the most volatile component of Gross Domestic Product (GDP) as a result of what Keynes said an “animal spirit”. Here, fiscal policy aims to restore the level of investment to boost the economy back into its pre-recession level. The final level of the hierarchy is when monetary policy is severely constraint and fiscal policy has only a limited set of instruments as a result of regulatory and political constraint. Then across the board tax cut and government spending can be used to boost consumption.

There are several reasons of why the policy hierarchy proposed by Mankiw and Weinzierl is reasonable. Over the past three decades there has been a strong trend for an independent monetary authority. An independent central bank seems to be a necessary, although not a sufficient, condition for better macroeconomic stability. Also, monetary policy seems to be closer to science than fiscal policy in utilizing a systematic analysis of alternative policies and their impacts. Clarida, et. al. (1999)[4] reviews the literatures on the state of the art of monetary policy and shows how monetary policy analysis are conducted based on rigorous theoretical foundation to assess various alternative policies with careful consideration their macroeconomic impacts. Monetary policy decision tends to be based on rigorous analysis on the dynamic behavior and expectation of economic agents in an economy with critical economic frictions, resulting into what can be thought as an optimal monetary policy.

In contrast, using Eric M. Leper’s[5] words, “fiscal policy choices spring from unsystematic speculation, grounded more in politics than economics”, of which he called fiscal policy as “alchemy”. Yet, potentially strong distributional impacts of fiscal policy make fiscal policy process inherently political. Democracy requires that any decision with regards to fiscal policy has to go through political process. The tendency that monetary seems to be more scientific-based and immune from political influence than fiscal policy thus makes the hierarchical policy proposed by Mankiw and Weinzierl reasonable.

How is the conduct of stabilization policy in Indonesia? It seems that political influences are still visible in the monetary authority although not as strong as in the fiscal counterpart. Regulation on Bank Indonesia vaguely states the independence of its monetary policy. Several legal cases involving parliament members and former official at Bank Indonesia indicate that Bank Indonesia is not yet independence. In terms of monetary policy process, it indirectly affects the credibility of monetary policy as shown by Harmanta, et. al. (2010).[6] The establishment of Otoritas Jasa Keuangan (OJK) should help clarify and strengthen the independent role of Bank Indonesia to conduct monetary policy.

Moving into fiscal policy process, the condition is worse. Recent legal cases clearly show how deep political influence in fiscal policy is. Bad institutional arrangement in the fiscal policy process has severely undermined the effectiveness of fiscal policy. Although it must be clearly understood that fiscal policy is inherently political, continuing process to improve institutional arrangement, governance and transparent process of fiscal policy must be an important priority for both government and parliament. Reform is clearly undergoing, but acceleration needs to be taken considering global economic uncertainty and domestic political situation if Indonesia is going to exploit all its potential especially with its current position as an investment grade country.

Related to the stabilization policy hierarchy and considering the current state and environment of stabilization policy in Indonesia, it might be better now for Indonesia to use monetary policy as a main tool for short-term macroeconomic stabilization and to use fiscal policy for longer term consideration.

[1] Staff at Fiscal Policy Office of the Ministry of Finance RI. The views in this very short essay are of the author and should not be reported as representing the views of Fiscal Policy Office or the Ministry of Finance.